iSixSigma

Operational Cost

Definition of Operational Cost:

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How much money do you need to operate your company for a year? How much could this number change throughout the year, and how different might it be in the next?

These questions might require some fancy footwork with your books, but it’s information you need to know. Companies need to have a firm grasp on their costs so they can prepare for success and prevent disaster.

Overview: What is operational cost?

A company’s operating costs, or opex, describes the total of all the expenses necessary to maintain normal production or services. Simply put, it’s the amount of money required to run the show. There are many types of expenses that all factor into the total costs of operating a business. Some of these are fixed values that only change with renewal of contracts, while others are variable and depend on fluctuations in the market.

3 drawbacks of operational cost

Lowering operational costs should always be among your primary business goals. Since profit margins are nothing more than the difference between your revenue and operating expenses, it can be just as profitable to cut your costs as it is to increase your income.

1. Higher costs for customers

Whether the rent costs for your properties went up or you have to spend more on base materials, it means your customers are probably going to pay more for your products. Passing along operating costs is a common practice, but it can also backfire if your prices go high enough to drive customers towards your competitors.

2. Loss of profitability

Businesses can run into serious problems if they shoulder the burdens of increasing operational expenses. If they are unable or unwilling to pass along these costs to customers, it can only mean cutting into their profit margins.

3. Difficulty expanding or attracting investors

Loss of profits from higher costs can rattle potential investors and send leadership into a survival mode instead of embracing a growth mindset. Delaying or canceling capital investments is sometimes a wise move, but it also means you won’t be expanding or growing as you could.

Why is operational cost important to understand?

You can’t control what you don’t understand. You need to know all about your operating expenses if you want to apply lean management practices and start cutting off the excess.

1. Fixed, variable or mixed

Just because it costs you a certain amount one year doesn’t mean it will cost that much next year. One of the first things you need to know about operational expenses is that there are several types: fixed, variable, and mixed. Fixed costs are relatively stable, like rent or salaries, while others can fluctuate from day to day.

2. Identifying uncontrolled costs

Understanding your costs allows you to pinpoint the costs that are truly out of your control. You can control what suppliers you use or what efficiency measures you implement, but you can’t control the global prices of base materials. Focus your efforts on the ones you can control.

3. Appreciate depreciation

It’s easy to forget maintenance, servicing and repair costs for company equipment alongside their depreciating value. Remember to calculate the operating costs incurred by loss of equipment value, including company vehicles and heavy machinery, incurred throughout the year.

An industry example of operational cost

A small pizza shop rents a place in a shopping center for $4,000 a month, which is a fixed cost that makes up a sizable portion of their expenses. There are several hourly employees that make an average of $13 an hour each, which are variable costs depending on how much they work. The shop also needs cheese, dough and various ingredients to provide their products. All of these are obtained at variable cost based on current market prices.

The shop has plenty of other costs related to maintaining their ovens and other essential kitchen equipment. They also incur a hefty power bill every month to run this equipment. These are variable costs that partially depend on employee performance. These expenses combined with the rent, employee wages and material costs all add up to the total operating cost of the shop.

3 best practices when thinking about operational cost

It’s really all about the details. The best practice you can implement is to be careful, thorough and keep an account of all your company’s finances.

1. Track all expenses

Tracking your expenses may seem like accounting 101, but it’s easy to let this lapse in smaller businesses. The truth is, you need to create a system and accountability for tracking all expenses no matter how big or small your operation.

2. Dive into details

Tracking should be as detailed as possible. Don’t just put a bunch of money in petty cash and let people use it for everything. Know what was spent on company meals versus travel costs. Know the difference between costs due to machine failures versus standard maintenance requirements.

3. Divide and conquer

While you should look into every area of expenses when streamlining your operation, you don’t necessarily need to do it all at once. It can help to focus on one area at a time and create stable, efficient processes that will serve you well in the years ahead.

Frequently Asked Questions (FAQ) about operational cost

1. What are direct and indirect operating costs?

Expenses can be divided into direct and indirect categories depending on their impact on the production process. Direct expenses are those that are immediately related to the production of a good or service, including materials and labor. Indirect costs are broader expenses, like property rent or licensing fees.

2. What are marginal costs?

Marginal cost is the exact or estimated amount your company would spend to produce one additional unit. The unit in question depends on the industry. It could be dental cleanings, cups of coffee, or cars off an assembly line.

3. What is cost function?

Cost function is actually an equation that shows how operating costs will scale with changes in production quantity. For example, your power bill will go up if you are producing more units, and employees cost more if they are working overtime to address an increase in sales.

Counting your costs

Counting the costs isn’t just about keeping accurate books, although that’s always an important goal. Knowing your costs is the first step towards cutting them. This practice helps you identify what expenses are crippling your profits and might even reveal some ways to reduce them. This information is also vital for making sound business decisions regarding new products, site expansion or other kinds of capital investment.

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